Income Tax Planning--The Kiddie Tax
Tax-planning techniques put aside in the early '90s when the difference between the highest and lowest income tax rates was narrow deserve a fresh look. The current almost 25% variation in rates means that the benefits in shifting income from someone in the highest bracket--39.6%--to someone in the lowest bracket--15%--just cannot be ignored.
To take one example, shifting income to a child even when the so-called kiddie tax applies may now be a more attractive option. The kiddie tax took away a major benefit of shifting large amounts of income to children by taxing the child's unearned income at the parents' higher rate. However, tax-saving opportunities remain primarily because the tax only applies to children under 14 at the close of the tax year and does not reach all income.
The age cap on the kiddie tax allows you to plan in a couple of ways. First, provided there is no dramatic reversal to a flat tax, you can expect the income on the property transferred to eventually be taxed at a lower rate than if you kept it. Also, even if the immediate income tax advantage is small you can take full advantage of an annual gift tax-free giving program knowing the income will be taxed at the child's rate once the child is 14. Second, you can transfer property that will produce the most income only starting after the year in which the child reaches 13. This may be accomplished, for example, if you follow special rules concerning U.S. Series EE savings bonds, under which interest income can be deferred until redemption or maturity. You can also transfer property that has built-in or expected appreciation. The idea here is that the property would not be sold until the gain would be taxed at the child's rate.
You can also get a modest savings because the first $650 ($700 in 1999) based on the standard deduction for a dependent is usually tax-free and the next $650 ($700 in 1999) is taxed at the 15% rate. Although, this only translates to a tax reduction of a few hundred dollars, any tax relief is usually welcome. Also, the $1300 ($1,400 in 1998 or 1999) tax-advantaged amount means that parents/grandparents can transfer a significant amount of income-producing assets.
Transferring capital assets to children also makes sense as a long-term investment, or even as a relatively short-term holding if a child is nearing age 14. Securities and other capital assets can be transferred annually to a child with no gift tax consequences if fair market value is not greater than $20,000 ($10,000 if a split-gift with a spouse is not made). Appreciation is not taxed until the assets are sold. If they are sold after the year in which the child reaches 13, the capital gain is taxed under the unmarried single tax bracket category. Because recent tax legislation reduced the long-term capital gain rate for assets held for more than 12 months (includes the donor's holding period), that long-term capital gain can be taxed at a low 10% when total taxable income for any given year does not exceed the 15% income tax bracket ($25,350 in 1998), and a low 20% on the balance.
One more thing: since the kiddie tax applies only to unearned income, parents who run their own business can effect modest savings if their child can legitimately be hired to work in the business, thereby taking advantage of the child's standard deduction which has been increased by $250 for employed dependents by the '97 Act. The new law has also increased and indexed for inflation the alternative minimum tax exemption amount of children under age 14.
Of course careful planning and attention to detail are necessary not only to achieve the intended tax consequences but also to ensure that any action fits in with your overall financial and family goals. Please do not hesitate to call if you would like to explore in greater detail any of the tax-saving ideas touched upon here or if you are interested in finding out about using trusts or the Uniform Gifts To Minors Act to your advantage.